Authors | Pankaj Jain, Madhuri Prabhakar
This blog post explores the new-fangled relationship between banks and online lenders, and how banks can leverage non-lending fintech companies to find better customers, focus on customer experience and better compete with their digitally savvy cousins – online lenders.
Emergence of the digital age in lending
In the aftermath of the 2008 financial crisis, banks have tightened their restrictions on lending; they tend to take fewer risks and lend only to the most conservative investments. This, coupled with technology advancements and a burgeoning demand for credit from small businesses and consumers alike, has led to the emergence of alternative lenders who actively cater to the underserved.
Over the past decade, online lending companies such as Lending Club, Upstart, Social Finance Inc. (SoFi) and Prosper among others have built billions of dollars of business by streamlining the previously slow and inefficient consumer lending market. Technology has restructured the lending industry and TransUnion data shows that fintech lenders now account for over a third of personal loan origination by volume.
These online lenders hold an edge over traditional banks mainly in terms of innovation and speed. The biggest players offer online and mobile applications, many of which can be completed in under 30 minutes. This is convenient and simple, compared to an average of 25 hours spent by small businesses on paperwork at around 3 banks before securing credit, according to the Federal Reserve Bank of New York's Fall 2013 Small Business Credit Survey.
Emerging digital lenders focus on advanced analytics and algorithms which allows them to automate a majority of the lending process, making them faster and more efficient underwriters. With the help of advanced Machine Learning (ML), they can use an array of traditional / bureau and non-traditional / alternate data sources to make intelligent and faster decisions on loan applications.
There has also been an advent of non-lending fintech companies such as Scienaptic Systems, ZestFinance and Underwrite.ai who offer this superior, new-age AI driven lending technology and platforms to banks to better compete with online lending companies.
Who owns the consumer?
The traditional lending model of Banks has clearly left gaps, which, with the help of technology, alternative lenders are finding profitable. However, the advantages of the new entrants could be tested if the current incumbents decide to fill the gaps with technology themselves.
The fact is that large banks and credit card companies have access to a majority of the consumer data, including information on activity within their existing accounts, cashflows and credit history. This data could result in powerful models, if combined correctly with alternate data and technology. It is relatively difficult for the new online lending companies to build meaningful models using AI and Machine Learning without this historic data.
Additionally, banks have their own balance sheets from which they can lend and don't have to raise high cost capital to compete with the online lending companies. Banks also charge the lowest interest rates, as alternative lenders offer costlier credit to compensate for their higher risk investments and flexibility. They also have an in-house client base, giving them a leg up in the race to the top.
Why would banks partner with their digitally savvy competitors?
Over the past few years however, banks have realized that they don’t necessarily have to compete with fintech companies. Banks feel that they can benefit from a powerful synergy by partnering.
Banks gain the ability to provide a better customer experience, increase loan originations, provide more loans. However, these capabilities can be quickly acquired by partnering with non-lending FinTech company minus the competition.
Online lenders gain a much-needed access to the banks’ customer data, financial services experience, and a familiarity with the regulatory environment.
Mike Cagney, CEO of the online lender SoFi, told Business Insider late last year that he was happy to partner up with Wall Street banks, adding that "It's good for the banks, because they need the assets, and it's good for us, because we need the funding, and it's a very symbiotic relationship."
A prime example in this space is JPMorgan Chase partnering with On Deck Capital to provide their customers small business loans, at the speed of an alternative lender.
“The Chase-OnDeck partnership will combine Chase’s relationships and lending with OnDeck’s technology platform. They will be able to offer almost real-time approvals and same or next-day funding.” OnDeck CEO Noah Breslow said. “Most banking execs now see that lending is moving online. Banks have a choice. They can build their own technology, or they can recognize that companies like OnDeck have already invested in it." He added.
One of the online lending companies, Upstart has started offering its technology to banks via software-as-a-service. BankMobile, the digital-only subsidiary of Customers Bank in Wyomissing, Pa., has become the first bank to start using online lending software developed by Upstart.
“We’re in alignment with bank-fintech partnerships but that’s also a myopic way of looking at the future, which is way beyond partnerships between banks and fintechs but also between banks and nonbanks, being able to create more engagement, loyalty, customer data and additional revenue streams.”, said Luvleen Sidhu, the President and Chief Strategy Officer of digital-only bank BankMobile, in an interview earlier this year.
Out of 200mn U.S. Consumers with FICO Credit scores, only around 40mn have a score above 800, qualifying them in the ranks of “super prime” borrowers. Each month, online lender SoFi distributes 15 million mailers, targeting these prime consumers, which drives a significant portion of their marketing budget. This puts SoFi in the same league as Goldman Sachs’ Marcus, which distributed 178 million pieces of direct mail in 2017 for marketing purposes.
Online lenders have had to build their customer base from ground up, while banks have the upper hand in terms of having an in-house pool of potential consumers. In this competitive environment, if banks decide to partner with online lenders, they would have to share this data, making them lose their edge.
Hence, the question remains – why a bank would use the platform of an online lending company that is competing with them to acquire the same client. Online lenders are the biggest beneficiaries in this partnership. For e.g. Valentin Stalf, a digital bank (N26 GmbH) CEO said in an interview, he wants big US banks' customers when he opens for business in the U.S. within the next year. He has one goal. To take 20 million customers from Wells Fargo.
Lending Relationships – Banks buying loans from Online Lenders
Banks that prefer an arrangement with some distance have the option to buy loans originated on an online lender’s platform. This type of partnership is common in the online SME lending space, with banks such as JPMorgan Chase and Bank of America buying assets from leading online lenders. Banks can choose to either retain these credits on their balance sheets, or re-package and securitize the loans to investors.
However, partnering with an online lender requires more than simply signing a contract. The FDIC recently emphasized that banks need to identify risks when partnering with digital lenders. The federal regulator stressed that the banks might lack extensive historical credit quality data due to their short tenures. The agency further said banks need to take into consideration the online lenders’ compliance with fair lending laws, anti-money-laundering rules and consumer protection requirements, among other applicable regulations.
All these checks would only be more cumbersome, as they require additional time and money to be spent by the bank, to ensure due diligence and credit quality before it adds the loan to its books. Instead, adopting new technology and customizing a non-lending Fintech company’s’ platform might be a better route for faster time to market minus the competition.
Dwindling Market Capitalization of Online Lenders
Though alternative lenders have been growing fast and are able to underwrite smaller loans, faster, their average lending rates have been extremely high, compared to traditional lenders. Since its founding in 2007, OnDeck has lent more than $3 billion to small business owners. However, its average rates have been in the 40s, drawing widespread criticism across the industry.
Additionally, faced with an upsurge in defaults after years of rapid growth, the biggest online lending platforms have been forced by bond investors to tighten underwriting standards. SoFi, Lending Club and Avant now demand higher average credit scores and offer shorter maturities.
Performance wise, 2016 was a rough year for online lenders and two prominent fintech companies saw their market valuations drop. One small-business lender abruptly stopped issuing loans temporarily due to performance issues, and another was forced to shut down. As a result, there is an increasing skepticism about the growth prospects of the entire industry.
Most of the online lenders were established in the wake of the financial crisis and haven't yet been through a market downturn. Recent trouble in the marketplace lending sector, including OnDeck's struggles to obtain funding, as a result of rising delinquencies seem to validate those concerns.
Regulation and Fiduciary Responsibility
There is a disagreement over the appropriate level of regulation of the online lending industry. As the market is still in its infancy, many experts caution against regulating too early or aggressively for fear of curbing innovation. On the flipside, there is concern that this could lead to the next subprime lending crisis if left unchecked.
Online lenders have been operating in largely unregulated markets and there are additional questions being raised about transparency and disclosure. Oversight and monitoring also needs to be addressed, as the online small business lending sector is not yet under the purview of federal regulations.
While the rules surrounding online lending are still gray, traditional banks have faced stricter regulations since the 2008 crisis and are more accountable due to greater standardization and transparency. Banks are the backbone of the economy, and hence have fiduciary responsibilities for financial inclusion. This makes them more reliable and sound in comparison, giving customers more confidence in the system.
Online Lenders are not as glitzy as they seem
A 2016 Federal Reserve survey revealed that customers have had issues with alternative lenders. Borrowers from online lenders report a significantly lower level of overall satisfaction (26%) compared to those who turn to traditional banks (75%). Online lenders may offer a faster application process, but the rest of the experience often disappoints. Borrowers were unhappy with their repayment terms (19%) and complained about unfavorable interest rates (33% compared to 3% for banks).
Many customers might also want to carry out certain types of finance related activities with the help of live agents. According to a PwC report from earlier this month, almost 60% of consumers surveyed, preferred to apply for a loan at a physical bank.
Banks, by nature, have some notable advantages. They have stable, low-cost funding, knowledge of regulations and expertise in managing credit risk in a turbulent economy. Armed with these competitive advantages, banks that innovate and leverage new digital lending technologies will be well-positioned to compete with alternative lenders.
Marcus by Goldman Sachs is an example of an internal fintech “startup”, that offers no-fee personal loans and online savings accounts. “Unlike fintech startups, we are a bank — and we’re proud to be a bank, because we’ve got a balance sheet, the DNA of risk management, and the ability to build a platform at scale”, commented Harit Talwar of Marcus.
Why Banks should partner with non-lending Fintech companies instead – The ‘Software as a service’ approach
Banks have multiple incentives to consider the ‘Software as a Service’ approach to updating their technology. For one, by partnering with a non-lending fintech, the cost and time of implementation is much lower than developing a solution in-house through a myriad of competing priorities. Secondly, banks can readily offer new products and services online under their own brand, thereby increasing their brand value with current and potential customers. Agile technology enables the banks to customize the platform to fit their lending practices and adapt to future changes. Additionally, since the loans will remain on the bank’s books, there is strong interest in collaborating with a non-lending fintech companies in this manner.
In a recent ABA report that surveyed close to 200 banks and financial institutions, 71% of respondents said their bank was interested in using a third-party digital platform for consumer loan origination. That figure was even higher (79%) for larger banks, those with assets above $1 billion.
The future of the industry is definitely digital. A report by Autonomous Research has indicated that digital lending could account for more than 10 percent of the US lending market by 2020. As lending moves online it is important for every bank to have an online lending strategy. Getting a loan online is something that some consumers are now getting accustomed to, but it is eventually going to be something they expect from every bank. The faster the banks get on board and update their technology, the better.